Those who invest in volatility-based ETFs are not receiving the same protection as those who invest in the VOLATILITY S&P 500 (INDEXCBOE:VIX) directly, claimed VIX inventor Robert Whaley at an EFT conference in New York. This came on the heels of William Speth of the Chicago Board Options Exchange, which manages the VIX, defending the product and its term structure at a Reuters HedgeWorld event in Chicago this week.

Market volatility VIX

People are not getting VIX

“People want VIX but they aren’t getting it,” Whatley, now a professor at the Vanderbilt University Owen Graduate School of Management said Thursday at’s Global Macro ETF Strategist Conference in New York. “They are getting a muted version of it.

Whatley, quoted in a Wall Street Journal article on the topic, said “VIX ETPs do not appear to provide insurance,” and investors are “much better off to be selling these products rather than buying them.”

Whatley’s charges come as the VIX, known as the “fear guage,” has come under attack recently as a “broken” indicator of volatility potential because of its historic low price, a charge broadcast this past Monday on CNBC by Sara Eisen. Speth, vice president of research and product development at the Chicago Board Options Exchange, addressed the charge on Wednesday at the Reuters HedgeWorld event.

The key point is that VIX is not ‘broken.’ Rather, it is a measure of expected market risk over the next 30 days. In order to get a sense of how the market views risk over different horizons, you have to look at a term structure of volatility,” Speth said. “CBOE helps traders visualize that term structure by calculating VIX indexes using 3, 6 & 12 month SPX options, respectively.”

VIX’s term structure

In the presentation Speth addressed different maturity structures in the SPX options, noting that the near term futures shows little probability of volatility in the next 30 days, he emphasized.  VIX futures and options are products that offer investors to protect against volatility at very specific times in the future. Most VIX futures quoted on business television are for the near month, which typically indicates low potential for market volatility.  Casual observers report this short term VIX contract as a proxy for overall volatility expectations in the market, but don’t often consider the time horizon.

When asked if put options – at the center of the VIX formula – were the best measure of stock market volatility, Speth defended the formula and discussed its subtle sophistication while sticking to the primary point. “On longer term time horizons the options indicate more potential for volatility than does the short term futures,” Speth said at the event.

ETF volatility proxy products not an accurate representation of VIX futures

It is this time horizon issue that is at the center of Whatley’s assertion that ETF volatility proxy products are not an accurate representation of the VIX futures and options product.

Getting into the weeds on the topic, Whatley hit what is known among derivatives professionals as the  “contango trap.” This simply means the price of a product further into the future is higher than the price at the present.

Imagine a hedge against a house by making a bet that the price of the house in the future will be at a higher level than the present. The closer one might get to the current point in time, the less that contract would cost.  The further out in time, the higher the potential cost of a house, if recent housing trends were to continue.

ETF products’ investing strategy

The ETF products Whatley describes might typically invest in more expensive hedges six months into the future, for instance, which indicates and protects against the higher likelihood of volatility deeper into the future than the current month. But there is a problem.

ETF products typically purchase the far out time horizons which are significantly more expensive than close in future, and someone is on the opposite side of this trade.  Professional volatility traders, some of whom were featured on the Reuters HedgeWorld volatility panel discussion with Speth, are known to sell the far month contract to ETF providers and hedge with the lower costing near month, a profitable trade for the professional volatility traders some period of time – and one core reason why the ETF volatility products are not generating the same returns as the VIX.